ABSOLUTE AND COMPARATIVE ADVANTAGE
Countries have to trade as they’re not able to produce everything that they want because
there's different levels of factor endowment and countries are better at different things.
Absolute advantage: a country can produce a good or service using fewer resources and at
a lower cost than other countries. On a table it's who made the most.
Comparative advantage: a country can
produce a good/service at a lower
opportunity cost than another country.
[opportunity cost for x = y / x].
A country can only have the comparative
advantage of one good. shows that total
production increases with specialisation,
as (assuming countries put 50% of their
resources into each good) double the
amount of the good that they specialise in.
shown graphically- the line producing more
has an absolute advantage but the gap
between the two lines on the X axis is
proportionally larger so it has comparative
advantage in that good.
More choice and lower prices for consumers Creates a trade deficit within countries net trade
Economies of scale for firms Increased unemployment (structural)
Higher economic growth and living standards Income inequality
Greater world output is an outward shift of the PPF/LRAS Creation of Global monopolies can kill small businesses
Assumptions as a limitation of comparative advantage:
- Assumes the market is perfectly competitive (its not)
- Ignores the change in exchange rates (if the price increases, the value increases)
- Assumes constant costs of production (its not, eg economies of scale)
- Ignores external costs of production (eg environmental issues)
- The world economy is more complex than just two countries (less relevant/useful)
- Ignores the diminishing marginal returns.
BALANCE OF PAYMENTS
BOP is a record of all financial transactions made in a country with the rest of the world and
its made up of the current account, the capital account, the financial account and the
international investment position.
,The current account:
Net trade- difference between the value of goods/services imported and those exported and
it can be split into trade in goods balance and trade in services balance.
Primary income- net earnings on foreign investment like profits/dividends/interest and net
cash transfers which income earned by domestic citizens who own assets abroad minus
income earned by foreign citizens who own assets in this country
Secondary income- money transferred between central governments which have no returns
like aid or grants
If more money enters the current account than leaves it, it's a surplus.
More money leaving than entering is a deficit which is financed by a surplus on the
capital/financial account
Deficits can be caused by: Surpluses can be caused by:
Relatively low productivity (rises unit costs) Rise in productivity
Relatively high inflation Long run competitive advantage
Relatively high value currency ( overvalued) Depreciating exchange rate
Rapid growth (more imports) Falling price of imported inputs
Inadequate investment/ innovation/R&D More savings than investment
Lower cost competition emerging Improvements in the terms of trade
These can be fixed by
Expenditure reducing: things to reduce aggregate demand like deflationary fiscal policy.
Spending on imports falls but domestic spending falls too.
Expenditure switching: protectionist measures to encourage domestic goods to be bought
instead of imports. Imperfect government information could lead to this causing currency
depreciation or domestic inflation as well as retaliation.
Supply side policies: education/training will improve productivity and the quality of exports to
boost their competitiveness and demand. It's anti inflationary (with a time lag) but if it's
achieved with privatisation it could lead to monopolies.
It's unclear whether an imbalance on the current account is significant but it's harder now
that countries are so interdependent. Large and persistent deficits are often financed by
unsustainable foreign loans which are affected by the confidence levels of other countries,
this can lead to falling living standards for consumers. Developing countries are more
vulnerable to this.
If a deficit is caused by inward investment, jobs and growth can be created which will allow
the debt to be repaid easily. Deficits can also signify growth, like you're giving a good return
to foreign investors.
The financial account: All transactions involved with changes of ownership of the UK’s
financial assets which involves investment.
Direct investment- FDI is capital received to and from a business by a foreign investor and is
the most important element
, Portfolio investment- investing in equities/debt securities
Financial derivatives- any financial instrument which is priced based on the value of an
underlying asset like currencies
Reserve assets- foreign financial assets which are controlled by the monetary authorities like
monetary gold.
The capital account:
Transactions in the ownership of fixed assets, known as capital transfers. This includes
immigrants and emigrants sending money home and government debt relief.
International capital flows happen because speculators can make profits by buying and
selling debt/shares based on guessing which currencies will appreciate in value. Banks and
firms also profit like this. Individuals may transfer money abroad for recreation (like a holiday
home) or for tax evasion.
An advantage of this would be that it facilitates growth by financing it as it provides capital for
firms that wouldn’t otherwise be able to have it, like those in developing countries. It also
transfers information and technology to developing countries.
Disadvantages include the fact that it shows vulnerabilities in the financial system of the
world as problems in one country will spread. It can lead to exploitation of countries by
MNCs which causes national security issues and possible retaliation. Similarly, it can
encourage overborrowing which has been responsible for financial crises.
Central banks:
Implementation of monetary policy:
The BoE and MPC tries to keep inflation within 2% by manipulating the interest rate
transmission mechanism and quantitative easing.
Banker to the government:
They handle government department accounts, give them short term advances, collect
payments to and from the government, advise them on new loans and control the sale of
government bonds.
Banker to the banks:
The lender of last resort to commercial banks when lending to each other (which is
preferable due to the lower libor interest rate) isn't possible because of things like liquidity
issues. This prevents a run on the bank panic situation
Regulating the banking industry:
The Financial Conduct Authority ensures honesty to protect consumers
The Prudential Regulation Authority promotes safety and stability of banks
The Financial Policy Committee monitors the risk/resilience of the system, i.e. stress testing.
Stress testing is running hypothetical scenarios annually (shocks from current econ cycle like
lower output, unemployment or interest rate) and biannually (more extreme unlikely
situations like a big bank failing). If they wouldn't have enough capital, action can be taken.
Countries have to trade as they’re not able to produce everything that they want because
there's different levels of factor endowment and countries are better at different things.
Absolute advantage: a country can produce a good or service using fewer resources and at
a lower cost than other countries. On a table it's who made the most.
Comparative advantage: a country can
produce a good/service at a lower
opportunity cost than another country.
[opportunity cost for x = y / x].
A country can only have the comparative
advantage of one good. shows that total
production increases with specialisation,
as (assuming countries put 50% of their
resources into each good) double the
amount of the good that they specialise in.
shown graphically- the line producing more
has an absolute advantage but the gap
between the two lines on the X axis is
proportionally larger so it has comparative
advantage in that good.
More choice and lower prices for consumers Creates a trade deficit within countries net trade
Economies of scale for firms Increased unemployment (structural)
Higher economic growth and living standards Income inequality
Greater world output is an outward shift of the PPF/LRAS Creation of Global monopolies can kill small businesses
Assumptions as a limitation of comparative advantage:
- Assumes the market is perfectly competitive (its not)
- Ignores the change in exchange rates (if the price increases, the value increases)
- Assumes constant costs of production (its not, eg economies of scale)
- Ignores external costs of production (eg environmental issues)
- The world economy is more complex than just two countries (less relevant/useful)
- Ignores the diminishing marginal returns.
BALANCE OF PAYMENTS
BOP is a record of all financial transactions made in a country with the rest of the world and
its made up of the current account, the capital account, the financial account and the
international investment position.
,The current account:
Net trade- difference between the value of goods/services imported and those exported and
it can be split into trade in goods balance and trade in services balance.
Primary income- net earnings on foreign investment like profits/dividends/interest and net
cash transfers which income earned by domestic citizens who own assets abroad minus
income earned by foreign citizens who own assets in this country
Secondary income- money transferred between central governments which have no returns
like aid or grants
If more money enters the current account than leaves it, it's a surplus.
More money leaving than entering is a deficit which is financed by a surplus on the
capital/financial account
Deficits can be caused by: Surpluses can be caused by:
Relatively low productivity (rises unit costs) Rise in productivity
Relatively high inflation Long run competitive advantage
Relatively high value currency ( overvalued) Depreciating exchange rate
Rapid growth (more imports) Falling price of imported inputs
Inadequate investment/ innovation/R&D More savings than investment
Lower cost competition emerging Improvements in the terms of trade
These can be fixed by
Expenditure reducing: things to reduce aggregate demand like deflationary fiscal policy.
Spending on imports falls but domestic spending falls too.
Expenditure switching: protectionist measures to encourage domestic goods to be bought
instead of imports. Imperfect government information could lead to this causing currency
depreciation or domestic inflation as well as retaliation.
Supply side policies: education/training will improve productivity and the quality of exports to
boost their competitiveness and demand. It's anti inflationary (with a time lag) but if it's
achieved with privatisation it could lead to monopolies.
It's unclear whether an imbalance on the current account is significant but it's harder now
that countries are so interdependent. Large and persistent deficits are often financed by
unsustainable foreign loans which are affected by the confidence levels of other countries,
this can lead to falling living standards for consumers. Developing countries are more
vulnerable to this.
If a deficit is caused by inward investment, jobs and growth can be created which will allow
the debt to be repaid easily. Deficits can also signify growth, like you're giving a good return
to foreign investors.
The financial account: All transactions involved with changes of ownership of the UK’s
financial assets which involves investment.
Direct investment- FDI is capital received to and from a business by a foreign investor and is
the most important element
, Portfolio investment- investing in equities/debt securities
Financial derivatives- any financial instrument which is priced based on the value of an
underlying asset like currencies
Reserve assets- foreign financial assets which are controlled by the monetary authorities like
monetary gold.
The capital account:
Transactions in the ownership of fixed assets, known as capital transfers. This includes
immigrants and emigrants sending money home and government debt relief.
International capital flows happen because speculators can make profits by buying and
selling debt/shares based on guessing which currencies will appreciate in value. Banks and
firms also profit like this. Individuals may transfer money abroad for recreation (like a holiday
home) or for tax evasion.
An advantage of this would be that it facilitates growth by financing it as it provides capital for
firms that wouldn’t otherwise be able to have it, like those in developing countries. It also
transfers information and technology to developing countries.
Disadvantages include the fact that it shows vulnerabilities in the financial system of the
world as problems in one country will spread. It can lead to exploitation of countries by
MNCs which causes national security issues and possible retaliation. Similarly, it can
encourage overborrowing which has been responsible for financial crises.
Central banks:
Implementation of monetary policy:
The BoE and MPC tries to keep inflation within 2% by manipulating the interest rate
transmission mechanism and quantitative easing.
Banker to the government:
They handle government department accounts, give them short term advances, collect
payments to and from the government, advise them on new loans and control the sale of
government bonds.
Banker to the banks:
The lender of last resort to commercial banks when lending to each other (which is
preferable due to the lower libor interest rate) isn't possible because of things like liquidity
issues. This prevents a run on the bank panic situation
Regulating the banking industry:
The Financial Conduct Authority ensures honesty to protect consumers
The Prudential Regulation Authority promotes safety and stability of banks
The Financial Policy Committee monitors the risk/resilience of the system, i.e. stress testing.
Stress testing is running hypothetical scenarios annually (shocks from current econ cycle like
lower output, unemployment or interest rate) and biannually (more extreme unlikely
situations like a big bank failing). If they wouldn't have enough capital, action can be taken.
